Monday, May 31, 2010

Marc Faber on Bloomberg: Bearish on Everything


Marc Faber : Mirror, Mirror on the Wall, When is the Next AIG to Fall?

Presented by Marc Faber at "Austrian Economics and the Financial Markets," the Mises Circle in Manhattan on 22 May 2010 in New York, New York. Includes an introduction by Mises Institute president Douglas E. French.

(from misesmedia, May 28, 2010)

Sunday, May 30, 2010

Peter Schiff on CNBC : Is U.S. the Next Greece or Japan?

(from CNBC, May 24, 2010)

Reflection Series: Is GDP An Obsolete Measure of Progress?

Since last summer the nation's Gross Domestic Product (GDP) has gone up — indeed, it grew at a surprising 5.7% rate in the 4th quarter — seeming to confirm what we've been hearing: the recession is officially over. But wait — foreclosure and unemployment rates remain high, and food banks are seeing record demand. Could it be that the GDP, that gold standard of economic data, might not be the best way to gauge a nation's relative prosperity?

Since it became the prime economic indicator during the Second World War (to monitor war production) many have criticized policy-makers' reliance on the GDP — and proposed substitute measures. For example, there is the Human Development Index (HDI), used by the UN's Development Programme, which considers life expectancy and literacy as well as standard of living as determined by GDP. And the Genuine Progress Indicator, which incorporates aspects of social welfare such as income equity, pollution, and access to health care. In the international community, perhaps the biggest nudge has come from French President Nicolas Sarkozy, who commissioned a report by marquee-name economists, including Nobel laureates Joseph Stiglitz and Amartya Sen, to find alternatives to what he calls "GDP fetishism". (See the best business deals of 2009.)

What exactly have we been fetishizing? Basically, market activity and growth. The GDP, generally expressed as a per-capita figure and often adjusted to reflect purchasing power, represents the market value of good and services produced within a nation's boundaries. Sounds reasonable. Until we consider what it doesn't measure: the general progress in health and education, the condition of public infrastructure, fuel efficiency, community and leisure.

"It's a narrow calculation of cash flow," says Hazel Henderson, President of Ethical Markets Media (USA and Brazil) and who co-developed the Calvert-Henderson Quality of Life Indicators, which unbundles, rather than averages, 12 indicators. "Because it's averaged, the GDP mystifies and masks the gap between rich and poor. I don't think there's ever been such a large disconnect between the GDP and what ordinary people are experiencing." (See TIME's 2009 Person of the Year: Federal Reserve Chairman Ben Bernanke.)

As an example of how what's good for the GDP is not always good for the individual, take health care: rising costs may be tough on families, but it boosts the GDP.

"The GDP is a truly terrible measure of things that really matter," says James Gustave (Gus) Speth, Distinguished Senior Fellow at Demos, a public policy research and advocacy organization based in New York. "Finally, there's a broad consensus on this point. For the first time there's a chance that this concern will move out of academic and research circles and become a real policy question."

Speth notes the seemingly paradoxical relationship between the growth rate (GDP) and decline in employment. "It takes enormous GDP growth to get jobs," he says. "It focuses us as a nation on a fool's errand."

One new calculation that's been attracting attention is the Happy Planet Index (HPI), which combines economic metrics with indicators of well-being, including subjective measures of life satisfaction, which have become quite sophisticated (HPI uses data from Gallup, World Values Survey, and Ecological Footprint). The HPI assesses social and economic well-being in the context of resources used, looking at the degree of human happiness generated per quantity of environment consumed. The HPI metric was driven in part by the recognition that the environmental costs of economic growth must be figured into standard-of-living reports. (See the worst business deals of 2009.)

"The GDP suited a different era and now we need a metric for our times," says Nic Marks, a Fellow at the London-based New Economics Foundation, and founder of its Centre for Well-Being. "During World War II production was important. After the war was the need for rebuilding. We're way past that. We need to account for our ecological footprint and see how we're operating on the planet. The GDP is often precisely wrong in that it's not measuring progress, just the making of stuff. The HPI is striving to measure a better future." One appeal of the GDP, says Marks, has been that it presents a simple message: up is "good"; down is "bad." "HPI is trying to mirror that simplicity, using one number as a headline indicator."

In terms of what the world wants measured, it seems the HDI and HPI have it over the GDP. For its report "International Public Opinion on Measuring National Progress: 2007" GlobeScan, a research firm based in Canada and London, surveyed 1,000 people in each of 10 countries not including the U.S.. When asked whether health, social and environmental status should figure into measures of national progress as much as economic data, between 70% (Russia) and 86% (France) agreed. "It's common sense and matches their experience," says Hazel Henderson, whose firm commissioned the study. "People know there is much valuable in their lives besides what can be expressed in monetary terms."

The matter of how a nation measures performance is far from trivial, says Gus Speth, particularly at a time when environment sustainability is on many people's minds. He observes: "You tend to get what you measure, so we'd better measure what we want." In other words, to a certain extent we are what we count. (See pictures of the stock market crash of 1929.)

For Nic Marks, the key shift introduced by the HPI is its "move away from measuring production and toward measuring consumption. The HPI serves as a signpost pointing more toward a society we want to live in — the delivery of good lives rather than the delivery of more goods."

So how does the U.S. fare in HPI terms? Not so good. It sits pretty far down the list at 114. The U.K. is 74, behind Germany, Italy and France. Topping the chart is Costa Rica, which has long life expectancy, high life satisfaction, and a per capita ecological footprint one-fourth the size of the U.S.

As Gus Speth explains it: "We [in the U.S. are] chewing up a lot of environment for not much happiness."

Reflection Series: WHAT'S WRONG WITH THE GDP?


table of contents

Since its introduction during World War II as a measure of wartime production capacity, the Gross National Product (now routinely measured as Gross Domestic Product—GDP) has become the nation's foremost indicator of economic progress. It is now widely used by policymakers, economists, international agencies and the media as the primary scorecard of a nation's economic health and well-being.

Yet the GDP was never intended for this role. It is merely a gross tally of products and services bought and sold, with no distinctions between transactions that add to well-being, and those that diminish it. Instead of separating costs from benefits, and productive activities from destructive ones, the GDP assumes that every monetary transaction adds to well-being, by definition. It is as if a business tried to assess its financial condition by simply adding up all "business activity," thereby lumping together income and expenses, assets and liabilities.

On top of this, the GDP ignores everything that happens outside the realm of monetized exchange, regardless of its importance to well-being. The crucial economic functions performed in the household and volunteer sectors go entirely ignored. The contributions of the natural habitat in providing the resources that sustain us go unreckoned as well. As a result, the GDP not only masks the breakdown of the social structure and natural habitat; worse, it actually portrays such breakdown as economic gain.


Since the GDP records every monetary transaction as positive, the costs of social decay and natural disasters are tallied as economic advance. Crime adds billions of dollars to the GDP due to the need for locks and other security measures, increased police protection, property damage, and medical costs. Divorce adds billions of dollars more through lawyer's fees, the need to establish second households and so forth. Hurricane Andrew was a disaster for Southern Florida. But the GDP recorded it as a boon to the economy of well over $15 billion.


The crucial functions of childcare, elder care, other home-based tasks, and volunteer work in the community go completely unreckoned in the GDP because no money changes hands. As the non-market economy declines, and its functions shift to the monetized service sector, the GDP portrays this process as economic advance. The GDP also adds the cost of prisons, social work, drug abuse and psychological counseling that arise from the neglect of the non-market realm.


The GDP violates basic accounting principles and common sense by treating the depletion of natural capital as income, rather than as the depreciation of an asset. The Bush Administration made this point in the 1992 report of the Council on Environmental Quality. "Accounting systems used to estimate GDP" the report said, "do not reflect depletion or degradation of the natural resources used to produce goods and services." As a result, the more the nation depletes its natural resources, the more the GDP goes up.


Superfund clean-up of toxic sites is slated to cost hundreds of billions of dollars over the next thirty years, which gets added to the GDP. Since the GDP first added the economic activity that generated that waste, it creates the illusion that pollution is a double benefit for the economy. This is how the Exxon Valdez oil spill led to an increase in the GDP.


By ignoring the distribution of income, the GDP hides the fact that a rising tide does not lift all boats. From 1973 to 1993, while GDP rose by over 50 percent, wages suffered a decline of almost 14 percent. Meanwhile, during the 1980s alone, the top 5 percent of households increased their real income by almost 20 percent. Yet the GDP presents this enormous gain at the top as a bounty to all.


In recent years, consumers and government alike have increased their spending by borrowing from abroad. This raises the GDP temporarily, but the need to repay this debt becomes a growing burden on our national economy. To the extent that Americans borrow for consumption rather than for capital investment, they are living beyond their means and incurring a debt that eventually must be repaid. This downside of borrowing from abroad is completely ignored in the GDP.


The Genuine Progress Indicator (GPI) is a new measure of the economic well-being of the nation from 1950 to present. It broadens the conventional accounting framework to include the economic contributions of the family and community realms, and of the natural habitat, along with conventionally measured economic production.

The GPI takes into account more than twenty aspects of our economic lives that the GDP ignores. It includes estimates of the economic contribution of numerous social and environmental factors which the GDP dismisses with an implicit and arbitrary value of zero. It also differentiates between economic transactions that add to well-being and those which diminish it. The GPI then integrates these factors into a composite measure so that the benefits of economic activity can be weighed against the costs.

The GPI is intended to provide citizens and policy-makers with a more accurate barometer of the overall health of the economy, and of how our national condition is changing over time.

While per capita GDP has more than doubled from 1950 to present, the GPI shows a very different picture. It increased during the 1950s and 1960s, but has declined by roughly 45% since 1970. Further, the rate of decline in per capita GPI has increased from an average of 1% in the 1970s to 2% in the 1980s to 6% so far in the 1990s. This wide and growing divergence between the GDP and GPI is a warning that the economy is stuck on a path that imposes large—and as yet unreckoned—costs onto the present and the future.

Specifically, the GPI reveals that much of what economists now consider economic growth, as measured by GDP, is really one of three things: 1) fixing blunders and social decay from the past; 2) borrowing resources from the future; or 3) shifting functions from the community and household realm to that of the monetized economy. The GPI strongly suggests that the costs of the nation's current economic trajectory have begun to outweigh the benefits, leading to growth that is actually uneconomic.

If the mood of the public is any barometer at all, then it would seem that the GPI comes much closer than the GDP to the economy that Americans actually experience in their daily lives. It begins to explain why people feel increasingly gloomy despite official claims of economic progress and growth.

The GPI starts with the same personal consumption data the GDP is based on, but then makes some crucial distinctions. It adjusts for certain factors (such as income distribution), adds certain others (such as the value of household work and volunteer work), and subtracts yet others (such as the costs of crime and pollution). Because the GDP and the GPI are both measured in monetary terms, they can be compared on the same scale.


Social breakdown imposes large economic costs on individuals and society, in the form of legal fees, medical expenses, damage to property, and the like. The GDP treats such expenses as additions to well-being. By contrast, the GPI subtracts the costs arising from crime and divorce.


Much of the most important work in society is done in household and community settings: childcare, home repairs, volunteer work, and the like. These contributions are ignored in the GDP because no money changes hands. To correct this omission, the GPI includes, among other things, the value of household work figured at the approximate cost of hiring someone to do it.


A rising tide does not necessarily lift all boats—not if the gap between the very rich and everyone else increases. Both economic theory and common sense tell us that the poor benefit more from a given increase in their income than do the rich. Accordingly, the GPI rises when the poor receive a larger percentage of national income, and falls when their share decreases.


If today's economic activity depletes the physical resource base available for tomorrow's, then it is not really creating wellbeing; rather, it is just borrowing it from future generations. The GDP counts such borrowing as current income. The GPI, by contrast, counts the depletion or degradation of wetlands, farmland, and non-renewable minerals (including, oil) as a current cost.


The GDP often counts pollution as a double gain; once when it's created, and then again when it is cleaned up. By contrast, the GPI subtracts the costs of air and water pollution as measured by actual damage to human health and the environment.


Climate change and the management of nuclear wastes are two long-term costs arising from the use of fossil fuels and atomic energy. These costs do not show up in ordinary economic accounts. The same is true of the depletion of stratospheric ozone arising from the use of chlorofluorocarbons. For this reason, the GPI treats as costs the consumption of certain forms of energy and of ozone-depleting chemicals.


As a nation increases in wealth, people should have increasing latitude to choose between more work and more free time for family or other activities. In recent years, however, the opposite has occurred. The GDP ignores this loss of free time, but the GPI treats leisure as most Americans do—as,something of value. When leisure time increases, the GPI goes up; when Americans have less of it, the GPI goes down.


The GDP counts as additions to well-being the money people spend just to prevent erosion in their quality of life or to compensate for misfortunes of various kinds. Examples are the medical and repair bills from automobile accidents, commuting costs, and household expenditures on pollution control devices such as water filters. The GPI counts such "defensive" expenditures as most Americans do: as costs rather than as benefits.


The GDP confuses the value provided by major consumer purchases (e.g., home appliances) with the amounts Americans spend to buy them. This hides the loss in well-being that results when products are made to wear out quickly. To overcome this, the GPI treats the money spent on capital items as a cost, and the value of the service they provide year after year as a benefit. This applies both to private capital items and to public infrastructure, such as highways.


If a nation allows its capital stock to decline, or if it finances its consumption out of borrowed capital, it is living beyond its means. The GPI counts net additions to the capital stock as contributions to well-being, and treats money borrowed from abroad as reductions. If the borrowed money is used for investment, the negative effects are canceled out. But if the borrowed money is used to finance consumption, the GPI declines.

The above text is excerpted from The Genuine Progress Indicator: Summary of Data and Methodology, Redefining Progress C1995. Copies of the full reports are available for $10.00 by contacting:
Redefining Progress, One Kearny Street, Fourth Floor San Francisco, CA 94108 Phone: 415-781-1191; FAX: 415-781-1198.

Thursday, May 27, 2010

Reflection Series: Gross Domestic Product


A Series Authored by Walter J. "John" Williams

"Gross Domestic Product"
(Part Five in a Series of Five)

October 6, 2004

Overstated GDP growth has meant that the 1990 and 2001
recessions were much more severe than recognized, and that lesser
downturns in 1986 and 1995 were more or less missed entirely.


The Gross Domestic Product (GDP) is one of the broader measures of economic activity and is the most widely followed business indicator reported by the U.S. government. Upward growth biases built into GDP modeling since the early 1980s, however, have rendered this important series nearly worthless as an indicator of economic activity. The analysis in this Installment will indicate that the recessions of 1990/1991 and 2001 were much longer and deeper than currently reported, and that lesser downturns in 1986 and 1995 were missed completely in the formal GDP reporting process. Furthermore, the current economic circumstance is suggestive of an early-1980s-style double-dip recession.

The distortions from bad GDP reporting have major impact within the financial system. For example, Alan Greenspan's heavy reliance on productivity gains to justify some of his policies is equally flawed, since the methods applied to GDP estimation influence the numerator in the productivity ratio. As with the CPI distortions discussed in Installment III, the Federal Reserve Chairman knows better.

With reported growth moving up and away from economic reality, the primary significance of GDP reporting now is as a political propaganda tool and as a cheerleading prop for Pollyannaish analysts on Wall Street.

Reporting Basics

The GDP is compiled and reported by the Bureau of Economic Analysis (BEA) of the Department of Commerce. Quarterly estimates are updated monthly, with the "advance" estimate published at the end of the first month following the close of a quarter. The first and second revisions are called the "preliminary" and "final" estimates. In turn the "final" estimate is revised in annual revisions (usually in July), and every five years or so a benchmark revision is published that revises all data back to 1929, the first year of formally estimated economic activity.[1]

The popularly followed number in each release is the seasonally adjusted, annualized quarterly growth rate of real (inflation-adjusted) GDP, where the current-dollar number is deflated by the BEA's estimates of appropriate price changes. It is important to keep in mind that the lower the inflation rate used in the deflation process, the higher will be the resulting inflation-adjusted GDP growth.

Due to a lack of good-quality hard data, the "advance" GDP report is little more than a guesstimate. The BEA comes up with three estimates of growth, a high, low, and most likely. The numbers then get re-massaged so that the reported growth rate is moved closer to whatever the economic consensus is expecting. There actually is a belief at the BEA that there is some value to economic consensus estimates.[2]

The estimation process does not improve much with the "preliminary" and "final" estimates. The BEA reports that 90% of ultimate revisions to the "final" estimate fall within a range of +3.1% to -2.6%. Where average growth has been about 3.5% over the years, that means that most reporting is not statistically significant. The upward bias shown in the revisions is due to what I call "Pollyanna Creep," where methodological changes regularly upgrade near-term economic growth patterns. These patterns will be explored shortly.

The GDP is a large component of the National Income and Product Accounts (NIPA), representing "the output of goods and services produced by labor and property in the United States."[3] The NIPA was the concept and development of the National Bureau of Economic Research, a private organization founded in 1920. The NBER work evolved into the BEA and the current NIPA accounting.

The NBER remains a consultant to the process and retains the position as official arbiter of U.S. recessions. At one time, the NBER did define a recession as two consecutive quarters of negative GNP/GDP growth that were not distorted by an event such as a truckers' strike.[4] The NBER used trends in indicators such as industrial production and payroll employment to time a recession's beginning and end, to the month. More recently, though, the NBER has abandoned the GDP as a recession indicator and has relied instead on those other economic series. My presumption is this change resulted from an unofficial recognition of the declining value of the GDP reports. In theory, the NBER is apolitical, although the timing of some of its recent calls on the ends of recession are suspect. Specifically, there is no such thing as a jobless recovery. If jobs are being lost, the economy still is in recession.

There Is a Problem in the Basic Structure

As part of the NIPA, the construct of the GDP is heavily reliant on economic theory for composition, unlike other data series such as retail sales or the trade deficit, which are relatively simple surveys that end up contributing to the GDP estimations.

The related Gross National Product (GNP) is the broadest U.S. economic measure and includes the GDP plus the balance of international flows of interest and dividend payments. For net debtor nations such as Guinea-Bissau and the United States, GDP usually will show the stronger growth than GNP, since the outflow of interest payments does not get charged against economic activity. For this reason, the United States switched its primary reporting from the GNP to the GDP in 1991. Put in perspective as of the "final" estimate of second-quarter 2004, annualized real GDP growth was 3.3%, down from 4.5% in the first quarter, while GNP growth for the same period was 1.9%, down from 3.9%.

I respect the intellect and creativity of those who have anchored their careers in academia. Frankly, though, most economic theories have little practical use in the real world. Concepts such as free trade being a boon to the world's economy [5], a weak currency helping turn a nation's trade deficit[6], or personal income including what the average homeowner would receive from himself in rental income if he charged himself to live in his own house, fall in to the "not in the real world" category.[7]

Varied academic theories, often with strong political biases, have been used to alter the GDP model over the years, resulting in Pollyanna Creep, where changes made to the series invariably have had the effect of upping near-term economic growth. Whether the change was to deflate GDP using "chain-weighted" instead of "fixed-weighted" inflation measures, to capitalize rather than expense computer software purchases, or to smooth away the economic impact of the September 11th terrorist attacks, upside growth biases have been built into reported GDP with increasing regularity since the mid-1980s.

The accompanying table shows the net impact of these changes over time. The GNP level for various years from 1929 through 1980 and GDP for 1980 and 1990 are shown in billions of current dollars. Once set, these GNP/GDP levels should not change. With redefinitions and methodological shifts, however, earlier periods have been restated so as to be on a consistent basis with the latest reporting. Accordingly, the GNP/GDP levels are shown as they were reported variously in 1950, 1984 and at present.[8]

What becomes evident when looking at these data is that the biggest reporting changes have taken place since 1984 and have accelerated coming forward in time. For example the 1980 GDP that had been reported as $2.708 trillion in 1992 had crept up by 2.9% to $2.786 trillion based on 2004 reporting. The 1990 GDP, however, had Pollyanna Creep of 5.3% over the same period.



Change in


Year 1950 1984 2004 2004/1992


GNP (Billions of Current Dollars)


1929 103.8 103.4 104.4 +0.97%

1933 55.8 55.8 56.7 +1.61%

1940 101.4 100.0 101.7 +1.70%

1950 284.2 286.5 295.2 +3.04%

1960 -- 506.5 529.5 +4.54%

1970 -- 992.7 1044.9 +5.26%

1980 -- 2631.7 2823.7 +7.30%


GDP (Billions of Current Dollars)


Change in

As Reported Reporting

in 1992 2004 2004/1992


1980 2708.0 2785.5 +2.86%

1990 5513.8 5803.1 +5.25%


Double-Entry Bookkeeping

The NIPA effectively is a double-entry bookkeeping system, where an item on the consumption side of the ledger, in the GNP/GDP accounts, is offset on the income side of the ledger, in Gross Domestic Income (GDI) accounts. In theory, the GNP and the GDI should be identical. In practice they rarely are, with the latest "statistical discrepancy" showing GNP to be $67 billion, or 0.6% higher than the GDI. This is due to the BEA's inability to reconcile the two series.

Part of the problem is that source data often are estimated without regard to actual numbers otherwise available. As an example of how far from reality the GNP/GDP/GDI reporting has gone, consider data from a high quality and unbiased resource: the Internal Revenue Service (IRS).

Based on its analysis of income tax returns, the IRS reports that, "For the second consecutive year, Adjusted Gross Income (AGI) fell, decreasing by 2.3% to $6.0 trillion for 2002. This represents the first time since prior to 1950 that total AGI reported on individual tax returns has fallen for two successive years."[9]

While one might expect to see some parallel income reporting in the GDI, it only happens by coincidence. Although the BEA considers the IRS data, it never has been able to reconcile the differences between GDI assumptions and IRS reality. Of course, the BEA sticks with the GDI assumptions, which have income rising in 2001 and 2002. The following table shows some of the specifics of comparable income components. Where wages and salaries are the single largest component in the GDI, they grew by 6.8% in 2002, according to the BEA, but the IRS reports a 0.4% contraction.



(Not Adjusted for Inflation)


Income Category IRS GDI


Wages & Salaries -0.4% +6.8%

Interest Income -20.9% -6.4%

Dividend Income -14.9% +5.1%


Part of the difference is in imputations, which gets back into the theoretical structure of the NIPA. Any benefit one receives, either living in one's own house, or receiving free checking from a bank has an imputed income component. Free checking, for example, is calculated as imputed interest income. Not only did imputed interest income account for 21% of all personal interest income in 2002, but also it grew at an annual rate of 8.3%! As an aside, renting the house you own from yourself gets imputed as 62% of total rental income.

Another issue is distortion in underlying series. The bias factors (now reported as net business birth/death modeling) inflate reported payroll employment, as discussed in this series' first installment. GDI estimates of wages and salaries are calculated off the payroll numbers and are inflated on a parallel basis.

Deflation Wonders

As emphasized earlier, the lower the inflation rate that is used to deflate the GDP, the higher will be the resulting inflation-adjusted growth.

One of the deflation stars is the computer. While computer prices have come down over time, the quadrupling and re-quadrupling of memories provided with a standard computer have, through hedonics and quality adjustments (see Installment III on the CPI), enhanced the decline in prices used in deflating computer consumption in the GDP. According BEA deflators, $1,000 computers bought in 1990, 1995 and 2000 would cost $48.63, $95.84 and $526.58, respectively, today. I bought computers in each of those time frames and could not replicate any one of them for the suggested proportionate price in deflated dollars, regardless of free memory enhancement.

One of the more significant changes to GDP inflation was made in 1996, when the deflator was shifted from fixed-weighted to a chain-weighted basis. The chain-weighted basis weights inflation for a two-year grouping of a related GDP component, rather than using the weighting of the benchmark year. One happy side effect of this change is that the components of inflation-adjusted GDP do not add up to the total, with the difference being allocated to the residual category. As of the "final" second-quarter 2004 real GDP, the residual was a negative $35.6 billion, or 0.33% of total GDP. The residual usually gets worse the more removed it is from the benchmark year, which is 2000 at present. As of the fourth-quarter 1990, for example, the residual is 13.4% of GDP. Before 1990, the BEA does not publish the detailed breakout of accounts, because of the large residual. For some reason, this bothers a number of well-reputed economists.

A Tempting Target for Manipulation

In the introduction to this series on government reporting, I mentioned political manipulation of the GNP/GDP in the Johnson and first Bush administrations that went beyond overly positive methodological changes. In both instances, my sources were consulting clients who had been involved directly in the process. In the latter instance, an individual at the BEA also confirmed the situation.

Few people argue with the GNP/GDP reports, so when Lyndon Johnson kept sending the initial GNP estimates back to the Commerce Department for correction, he eventually got what he wanted, and the media dutifully reported stronger than actual economic growth.

Near the end of the first Bush administration, an outside-the-system manipulation was worked. A senior member of the Executive Branch approached a senior officer of a large computer company and requested that reporting of computer sales to the BEA be inflated. This was done specifically to help with the reelection effort. The request was granted, and thanks to the heavy leverage of computer deflation, reported GDP growth enjoyed an artificial spike.

There are suggestions of other direct manipulations over time, specifically involving the Clinton administration and the current Bush administration. Most recently, a bizarre annual revision to the GDP data eliminated the 2001 recession, at least as traditionally defined with two consecutive quarters of real GDP contractions.

Where little public attention is paid to the GDI, however, it is interesting to note that the revisions did not follow the same pattern on the inflation-adjusted income side of GDP. Pre-revision numbers showed quarterly real GDP contractions in third-quarter 2000 and the first- through third-quarter 2001. In the 2004 annual revisions, second-quarter 2001 GDP growth turned positive (from -0.6% to +1.2%), breaking up any consecutive quarterly GDP declines. The patterns were repeated in revisions of the GNP. Following the latest annual revisions, however, the GDI-same as GNP in theory-showed contractions in fourth-quarter 2000, second- through fourth-quarter 2001 and third-quarter 2002.

Estimating Economic Reality

Based on my analysis of the GDP/GNP revisions and redefinitions over time, over-deflation and economic reporting as published before later political corrections, reporting of real GDP growth at present is overstated by roughly three percent per year against a more realistic, pre-Pollyanna Creep period.

Where the period of bloated GDP reporting began after the severe double-dip recession of 1980 and 1981/1982, it includes the last two recessions that were severe enough to generate reported GDP contractions. Both the 1990/1991 and 2001 recessions were deeper and longer than currently estimated. The recession from July 1990 to March 1991 (timing per the NBER) really began in late-1989 and persisted into 1992, perhaps even 1993. Such was evident in the underlying data of the time. Due to the NBER's early call of the recession's end, however, the first "jobless recovery" was seen.

Similarly, the recession that was timed from March to November 2001, began in late-2000 and persisted into 2003. Again, because of an early call to the recession's end, a "jobless recovery" was seen.

There also were economic downturns in 1986 and 1995 that were evident to most companies dealing in real world economic activity at he time. Although the contractions showed up in a number of measures, they were not severe enough to turn bloated GDP growth negative.

As the economy once again appears to be faltering, or losing traction, risk is high of renewed or a double-dip recession, of which the 2001 downturn eventually will be counted as the first leg.

I have only touched upon some of the highlights in problems with GDP reporting. Unfortunately, though widely followed, the series is probably the least meaningful of the major economic statistics followed by investors and the financial media.

Footnotes to Installment Four

[1]Full definitions and methodologies are available at the BEA's wbsite BEA.

[2]The information on the guesstimation process is based on my conversations with individuals at the BEA during the last 25 years. The economic consensus misses turning points in the economy about 100% of the time.


[4]Though the NBER now denies such a definition was ever used, the NBER supplied me with this definition in a conversation back in the 1980s.

[5]Free trade theory assumes all involved nations are at full employment. When that is not the case the wealthiest and highest salaried countries end up with a declining standard of living and redistributing their wealth to the other free-trade participants, as is the current circumstance for the United States.

[6]While currency values can have relatively quick impact on trade in pure commodities, products with quality differentiation combined with the financial and marketing creativeness of importers and exporters often bypass standard theory.

[7]This is an actual component of the income side of the GDP.

[8]BEA, various historical editions of the Statistical Abstract of the United States, Department of Commerce.

[9]Individual Income Tax Returns, Preliminary Data, 2002, IRS website IRS.

Tuesday, May 25, 2010

Whitney Talks Small Biz

CNBC May 17, 2010
Why small businesses could see a further credit crunch, with Meredith Whitney, Meredith Whitney Advisory Group.

The Importance of the Macro-Political Landscape and How David Einhorn Used It to Predict 2010

Submitted by Qasim Khan

Perhaps one of the most overlooked phenomena in this world is the relationship between cause and effect. Financial markets and economics in general are often noteworthy exhibitions of a lack of recognition of this principle. In just a few minutes watching CNBC, you are bombarded with statistics that PROVE our miraculous economic recovery. The macro data has become better; anyone who denies that is disconnected from reality. However, as the markets have vehemently demonstrated recently, the fact is that these numbers have become increasingly irrelevant. Why you ask? Because we don’t live in a society where these numbers represent organic, secular conditions anymore; instead, they reflect the increasingly contradictory and escalating political tension of the world.

Importance of Geo-Politics

While CNBC talks about things like CPI, PMI, and Cramer’s PMS instead of bigger picture geo-political developments, their importance cannot be understated. And while many traders and investors do not heavily account for such macro elements (evidenced by the fact that the global economy could be brought to its knees by a largely unforeseen housing bubble), David Einhorn, whom I have had the fortune of meeting, perfectly explains the importance of this in a speech to the Value Investing Conference in October 2009. Einhorn, known for his bottom up investment style, found a greater appreciation for the importance of macro developments after the recent financial crisis. In the speech he offers several extremely poignant predictions based upon this macro-political perspective, almost completely vindicated by the events in 2010. He said:

At the May 2005 Ira Sohn Investment Research Conference in New York, I recommended MDC Holdings, a homebuilder, at $67 per share. Two months later MDC reached $89 a share, a nice quick return if you timed your sale perfectly. Then the stock collapsed with the rest of the sector. Some of my MDC analysis was correct: it was less risky than its peers and would hold-up better in a down cycle because it had less leverage and held less land. But this just meant that almost half a decade later, anyone who listened to me would have lost about forty percent of his investment, instead of the seventy percent that the homebuilding sector lost.

I want to revisit this because the loss was not bad luck; it was bad analysis. I down played the importance of what was then an ongoing housing bubble. On the very same day, at the very same conference, a more experienced and wiser investor, Stanley Druckenmiller, explained in gory detail the big picture problem the country faced from a growing housing bubble fueled by a growing debt bubble. At the time, I wondered whether even if he were correct, would it be possible to convert such big picture macro thinking into successful portfolio management? I thought this was particularly tricky since getting both the timing of big macro changes as well as the market’s recognition of them correct has proven at best a difficult proposition. Smart investors had been complaining about the housing bubble since at least 2001. I ignored Stan, rationalizing that even if he were right, there was no way to know when he would be right. This was an expensive error.

The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture. For years I had believed that I didn’t need to take a view on the market or the economy because I considered myself to be a “bottom up” investor. Having my eyes open to the big picture doesn’t mean abandoning stock picking, but it does mean managing the long- short exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time.


This ideological change has become apparent in the market more generally as well. CNBC can toot all the numbers and expectations they want, the truth is economic data has taken a back seat to political circumstances in the new market.

To understand the causal dynamics of the current recovery it is necessary to ask “how” and “why” instead of asking the much trumpeted CNBC question of “what”. From this perspective it becomes clear that the “recovery” that we have experienced draws heavily on exceptionally generous intervention. The government response was in all likelihood necessary and has resulted in improved economic data; however, it seems that the stimulus improved the (certain) numbers simply for the sake of improving (certain) numbers. As this has become increasingly apparent, there has been a paradigm shift where political conditions and events increasingly overwhelm economic data and appear to continue to do so for the foreseeable future.

Perhaps the most pressing question is: “How much longer can sovereign governments afford to provide extremely loose conditions and subsidize private sector debt?” So how early is too early to remove stimulus? Einhorn wisely prophesied that government response to the financial crisis would make previously economic issues become subject to politics:

Imagine, in our modern market, where we now get economic data on practically a daily basis, living through three years of favorable economic reports and deciding that it would be “premature” to withdraw the stimulus.

An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.

This brings me to our present fiscal situation and the current investment puzzle.

Over the next decade the welfare states will come to face severe demographic problems. Baby Boomers have driven the U.S. economy since they were born. It is no coincidence that we experienced an economic boom between 1980 and 2000, as the Boomers reached their peak productive years. The Boomers are now reaching retirement. The Social

Security and Medicare commitments to them are astronomical.

When the government calculates its debt and deficit it does so on a cash basis. This means that deficit accounting does not take into account the cost of future promises until the money goes out the door. According to, if the federal government counted the cost of its future promises, the 2008 deficit was over $5 trillion and total obligations are over $60 trillion. And that was before the crisis.

Over the last couple of years we have adopted a policy of private profits and socialized risks. We are transferring many private obligations onto the national ledger. Although our leaders ought to make some serious choices, they appear too trapped in short-termism and special interests to make them. Taking no action is an action.

In the nearer-term the deficit on a cash basis is about $1.6 trillion or 11% of GDP.

President Obama forecasts $1.4 trillion next year, and with an optimistic economic outlook, $9 trillion over the next decade. The American Enterprise Institute for Public Policy Research recently published a study that indicated that “by all relevant debt indicators, the U.S. fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default.”

As we sit here today, the Federal Reserve is propping up the bond market, buying long-dated assets with printed money. It cannot turn around and sell what it has just bought.

There is a basic rule of liquidity. It isn’t the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because of both the size of the position and the signal my selling would send to the market. For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up.

Further, the Federal Open Market Committee members may not recognize inflation when they see it, as looking at inflation solely through the prices of goods and services, while ignoring asset inflation, can lead to a repeat of the last policy error of holding rates too low for too long.

At the same time, the Treasury has dramatically shortened the duration of the government debt. As a result, higher rates become a fiscal issue, not just a monetary one. The Fed could reach the point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort.


The unsustainable nature of the interventionist mandate is becoming increasingly apparent, evidenced by the explosion of sovereign debt concerns this year. This crisis has resulted in a reexamination of the importance of fiscal discipline and introduction of austerity plans in Europe. While the US states do not face the same difficulties as their European counterparts, their problems may be just as difficult to overcome.

This past week, the great city of Central Falls, Rhode Island was placed in receivership, which comes as a tremendous surprise because the city website’s slogan led me to believe that Central Falls was “A City with a Bright Future.” It’s funny that their website failed to mention that its public school system was universally accepted to be well below satisfactory standards; so poor in fact that in February the Board of Trustees voted to fire the ENTIRE teaching and administrative staff of the school system. As misplaced or harsh as this measure may have been (clearly such systemic problems have more than one causal source), being labeled as “persistently lowest-performing” and having a 48% graduation rate is simply unacceptable. It is not surprising to find this result was an product of monetary union conflict. The articles points out:

Duncan is requiring states, for the first time, to identify their lowest 5 percent of schools — those that have chronically poor performance and low graduation rates — and fix them using one of four methods: school closure; takeover by a charter or school-management organization; transformation which requires a longer school day, among other changes; and “turnaround” which requires the entire teaching staff be fired and no more than 50 percent rehired in the fall.

Gallo and the teachers initially agreed they wanted the transformation model, which would protect the teachers’ jobs.

But talks broke down when the two sides could not agree on what transformation entailed.

Gallo wanted teachers to agree to a set of six conditions she said were crucial to improving the school. Teachers would have to spend more time with students in and out of the classroom and commit to training sessions after school with other teachers.

But Gallo said she could pay teachers for only some of the extra duties. Union leaders said they wanted teachers to be paid for more of the additional work and at a higher pay rate — $90 per hour rather than the $30 per hour offered by Gallo.

After negotiations broke down, Gallo said she no longer had confidence the high school could be transformed and instead recommended the turnaround model. Gist approved Gallo’s proposal Tuesday morning and gave the district 120 days to develop a detailed plan.

So let’s get this straight: the students were performing so poorly that in order demand more commitment from teachers, they should be paid an even greater amount? It’s no wonder why the school system would be so fundamentally unproductive. While I don’t believe a teacher would purposely sabotage their students, the breakdown of talks demonstrates that the teachers were not committed to the job they should already be doing. Talk about moral hazard. But it turns out that the problem of paying its current teachers was minor in comparison to the true problem of paying retired teachers, as this article points out:

“The pension plan is nearly broke,’’ said Joseph Larisa, a lawyer who argued in court yesterday for the receivership. “It’s really reached a breaking point where the budget cannot be balanced, whoever is in charge.’’

And if you believe that Central Falls is the only municipality struggling with its pension commitments, you might find this NYT piece quite enlightening. While Central Falls may be insignificant in the larger scheme of things, make no mistake, austerity measures will take place within the US and they will result serious consequences.

Geo-political Tension

And while the fiscal difficulties of the public sector are the flavor of the day, potentially much more dangerous geo-political tensions are developing throughout the world.

While posting a trade deficit in March has calmed the domestic calls for the appreciation of the Yuan, I doubt anyone would characterize the US-Chinese dynamic as warm. The Google censorship conflict presents an altogether different political challenge and I’m sure Hilary Clinton’s remarks today calling for China to increase corporate freedom and transparency failed to improve relations. Slowly but surely, we are seeing China capitalize on its economic power to gain political power, something that the US has largely had a monopoly upon the previous century or so.

While Thailand has seen its share of troubles, the conflict between the Koreas dominates the Asian soft-power political landscape. North Korea just happened to torpedo and sink a South Korean naval ship, killing 46 sailors. SoKo, understandably, wanted to make a strong statement of retaliation, but then remembered North Korea is nuclear and it isn’t. So they’re taking their case to the almighty UN Security Council, where they are left at the whims of regional giant and their biggest trading partner, China, which has yet to state a formal policy on the sinking of the ship. Can’t piss off China, can’t piss of North Korea… something will have to give eventually.

Speaking of nuclear issues, Iran continues to pose the biggest threat to the global economy and it does not appear likely to improve any time soon. Not only did the US fail to secure the release of three jailed American journalists in Iran despite having released two Iranian citizens held by US forces in Iraq and their mothers visiting them in Iran, it appears that it is losing credibility in the nuclear development conflict as well, evidenced by a recent interview with President Ahmedinejad on Al Jazeera:

In an exclusive interview conducted by the Al Jazeera network on Friday, Ahmadinejad stated that no country has the power to confront Iran, and added that Tehran advocates diplomacy as the ideal way to deal with international issues, the Fars news agency reported.

Ahmadinejad said Iran does not even take Israel into account and noted that Tel Aviv is not able to wage a war against the Islamic Republic.

On the deteriorating relations between Tehran and the West, Ahmadinejad said Western countries don’t have problems only with Iran but actually have problems with every country.

While the last quote is surprisingly insightful, once again Ahmedinejad leaves observers miffed. Don’t have the power? Apparently he missed the massive naval buildup in the Persian Gulf that the US has begun

Our military sources have learned that the USS Truman is just the first element of the new buildup of US resources around Iran. It will take place over the next three months, reaching peak level in late July and early August. By then, the Pentagon plans to have at least 4 or 5 US aircraft carriers visible from Iranian shores.

This situation is quite literally a perfect storm combining a lunatic head of state, nuclear weapons, oil and of course Israel. Particularly with respect to crude, who knows how long Obama can stick to his pro-drilling position as the oil spill has gone on for so long now that everyone seems to have either forgotten about the issue or submitted their best idea to BP. Just today, Iran threatened to abandon shipping some of its nuclear stockpile abroad as was planned if the US pursued increased sanctions against it; it will be interesting to see just how far the Obama administration is willing to press Iran on its nuclear aims.

The Moral Bankruptcy of Hamid Karzai

Oh and did we forget to mention the US is still conducting military operations in Iraq and Afghanistan? The economic costs of which, pointed out here perhaps somewhat satirically by Congressman Alan Greyson, are completely ignored. The situation in Afghanistan is particularly perplexing, epitomized by the enigma that is Hamid Karzai.

Here is a situation where we have a president who is quite literally telling us he supports the American effort while speaking English and the Taliban when speaking Pushto. No that’s not an exaggeration. He literally threatened to join the Taliban.

This is the same president who needed to commit severe election fraud to prevent a runoff election with a man named Abdullah Abdullah (if you’re not supposed to trust a man with two first names, how in the hell do you even consider trusting a man with two first names that just happen to be the same?). The same president who had one-third of his votes thrown out by a UN-backed fraud commission. The same president who then tried to take over the investigation commission that was supposed to look into fraud in last August’s election and then accused the UN of rigging the election, despite the fact that it was the UN who backed the investigation that revealed the massive fraud. The same president whose brother just shut down the regional council in Kandahar while he is being investigated for illegally appropriating government land. Oh and by the way, our success in the operation absolutely depends entirely upon securing Kandahar, the Washington Post points out. While Will Smith doesn’t believe in backup plans, I don’t think this is exactly what he envisioned.

Of course, not all of these tensions will escalate to have significant economic ramifications, but they just serve to show there is no lack of exogenous catalysts posing a threat to an increasingly global economy.

Politics and Gold

Perhaps the most politically contentious investment currently is gold. Gold, the asset that has no yield and no obvious pragmatic purpose has breached all time highs; and with such success inevitably comes much abuse, confusion and controversy. As seen by the recent Goldline-Glenn Beck- Anthony Weiner situation, the value of gold is primarily driven by political expectations. With the rise of the Tea Party movement producing legitimate candidate threats (although Rand Paul may have shot himself in the foot) gold will only continue to become more contentious. Once again, Einhorn shrewdly foretold:

I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when

FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker’s austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked.

Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely. Of course, gold should do very well if there is a sovereign debt default or currency crisis.

A few weeks ago, the Office of Inspector General called out the Treasury Department for misrepresenting the position of the banks last fall. The Treasury’s response was an unapologetic expression that amounted to saying that at that point “doing whatever it takes” meant pulling a Colonel Jessup: “YOU CAN’T HANDLE THE TRUTH!” At least we know what we are dealing with.

When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the “stimulus” black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And especially now, where both earn no yield.

I believe there is a real possibility that the collapse of any of the major currencies could have a similar domino effect on re-assessing the credit risk of the other fiat currencies run by countries with structural deficits and large, unfunded commitments to aging populations.

I believe that the conventional view that government bonds should be “risk free” and tied to nominal GDP is at risk of changing. Periodically, high quality corporate bonds have traded at lower yields than sovereign debt. That could happen again. [editor's note: a possibility mentioned on ShadowCap on multiple occasions]


The final piece of the political-financial landscape is regulation, a topic that has seen dramatic developments recently in the US. Here, perhaps more so than anywhere else, the global economy is purely subject to the flighty whims of politics. As such, regulation, while theoretically desirable, may pose the greatest threat of all because it never seems to deliver on its intended aims. Einhorn:

Rather than deal with these simple problems with simple, obvious solutions, the official reform plans are complicated, convoluted and designed to only have the veneer of reform while mostly serving the special interests. The complications serve to reduce transparency, preventing the public at large from really seeing the overwhelming influence of the banks in shaping the new regulation.

In dealing with the continued weak economy, our leaders are so determined not to repeat the perceived mistakes of the 1930s that they are risking policies with possibly far worse consequences designed by the same people at the Fed who ran policy with the short- term view that asset bubbles don’t matter because the fallout can be managed after they pop.

That view created a disaster that required unprecedented intervention for which our leaders congratulated themselves for doing whatever it took to solve. With a sense of mission accomplished, the G-20 proclaimed “it worked.”

And that is the message that the Administration is trying to send with the new financial reform bill that passed the Senate: Mission Accomplished. And that is how you end up with a new “consumer protection” agency, when we already have a obfuscated system of overlapping and redundant institutions.

Anyone who objectively observes the incentives of the current political establishment objectively is forced to admit that what regulation produces more so than anything else is more regulation. So while the SEC is busy surfing the web desperate waiting for the new Kendra sex tape, we have a new institution to place the blame upon when the next crisis inevitably occurs.

Financial reform was clearly passed now so the administration can claim a win for upcoming mid-term elections, however it is beyond all hilarity that the “reform” completely leaves the issues with GSEs and rating agencies unaddressed. Bill Gross has recently been on a campaign against rating agencies. Once again, Einhorn points out:

And, of course, these structural risks are exacerbated by the continued presence of credit rating agencies that inspire false confidence with potentially catastrophic results by over-rating the sovereign debt of the largest countries. There is no reason to believe that the rating agencies will do a better job on sovereign risk than they have done on corporate or structured finance risks.

My firm recently met with a Moody’s sovereign risk team covering twenty countries in Asia and the Middle East. They have only four professionals covering the entire region. Moody’s does not have a long-term quantitative model that incorporates changes in the population, incomes, expected tax rates, and so forth. They use a short-term outlook – only 12-18 months – to analyze data to assess countries’ abilities to finance themselves. Moody’s makes five-year medium-term qualitative assessments for each country, but does not appear to do any long-term quantitative or critical work.

Their main role, again, appears to be to tell everyone that things are fine, until a real crisis emerges at which point they will pile-on credit downgrades at the least opportune moment, making a difficult situation even more difficult for the authorities to manage.

Hm… we haven’t seen this exact problem in the Eurzone now have we? Globally we are seeing the effects of increased regulation, as Chinese tightening has set off a wave of fear in the region and a recently proposed mining tax on the heavily commodity based economy in Australia helped send the AUD plunging this past week. In the US, financial reform has spilled into the electoral arena, complicating an already far too convoluted project.

Take for example the new derivative amendment proposed by Arkansas Senator Blanche Lincoln, which almost no one takes seriously. Hell, even Paul Volcker opposes the amendment. Yet surprise, surprise with an upcoming election it was created for political gain and has remained because of political risk. A recent Bloomberg piece points out:

Regulators “have come out in a really unusual way and said, and I’m paraphrasing here, that this is a really, really stupid idea,” Senator Judd Gregg, a New Hampshire Republican, said in a recent floor speech. “Where this idea came from is hard to fathom because on the face it makes absolutely no sense. Yet for some reason it has found its way into this bill.”

Regardless of the outcome, Lincoln has reaped political gain. In a fundraising letter sent April 16, she said she was “proposing sweeping legislation that would drastically change the way Wall Street does business.”

On May 4, her campaign began airing a radio advertisement featuring President Barack Obama. “Blanche is leading the fight to hold Wall Street accountable and make sure that Arkansas taxpayers are never again asked to bail out Wall Street bankers,” Obama said.

And this is why all I can do is laugh when I see politicians crucifying Goldman for having conflicts of interest. Because if anyone has a conflict of interests, it is politicians. The recent actions of Blanche Lincoln and Arlen Spector demonstrate just how repulsive politics is ethically. Arlen Spector quite literally admitted his only reason for changing parties was to save his job, so it’s not really a wonder that he couldn’t secure the primary bid.

But such actions are the rule, rather than the exception. Every time I turn on the news to see a headline that reads something like BREAKING NEWS: State Attorney General Cuomo Declares Gubernatorial Candidacy, I am reminded at how seriously flawed the political environment currently is and its dominating influence over financial markets. For example, any reasonably intelligent human being could surmise that Cuomo already did this when he started conducting criminal investigations into Wall St practices that will undoubtedly result in absolutely nothing of substance.

So while I agree the Fed opacity presents a concern, I would be far more concerned if it had to report to the GAO or any other Congressional body because while Bernanke is certainly guilty of hubris, many Congressman are guilty of the far worse crime of absolute idiocy. Checks and balances are extremely important in theory, however, they can be equally unproductive if involved parties are incompetent.

However, that’s exactly where we are today; financial markets are a game of politics right now. It’s nice to see the unemployment rate tick up one-tenth of one percent or manufacturers gaining confidence, however when you understand the causal sources of these changes, they truly become much less important. When the Fed has a balance sheet of over $2T, Fannie and Freddie are still backing every mortgage in sight, and ZIRP is fueling banking profits (while will continue for a significant amount of time), it is no wonder. This trend looks like it will continue as well.

Everyone knows that such a path is unsustainable (although the United States enjoys a clear advantage in maintaining such conditions because of disastrous game theory political implications). Make no mistake, the intervention has had tremendous effects; however, the effects are not done and there will be a day of reckoning.

(from ShadowCapitalism, May 24, 2010)

Sunday, May 23, 2010

Jim Walker, Asianomics: Fear is back; global growth deteriorating

It seems that fear is coming back to financial markets in a big way and financial conditions are turning bad again, isn’t it?

Yeah, I am afraid that’s right but I certainly see on the radar screen it’s obviously led by what’s happening in Southern Europe. But it’s not just Southern Europe. I think people need to be aware that one of the main reasons behind this heightened fear is the fact that governments are being forced to exit stimulus programmes whether it’s slightly higher interest rates in India, tightening in China, rigid fiscal deficits in Europe and US - all of that.

There is a real doubt on whether or not the private sector is truly on the move after what’s happened in the last 18 months. The figures show that certainly there is not very much appetite in the private sector for increased investment and that’s what we need to increase employment. So I think the fear is right back and global growth - I am afraid - is deteriorating again, it’s not improving.

What about the Eurozone because Nouriel Roubini is talking about a potential breakup of the Eurozone, Paul Krugman is saying that Europe may not have been an optimal currency area to begin with? What are your thoughts?

Well I am kind of surprised at the statement by Paul Krugman. We realised that it really never had the conditions for being an optimal currency zone. Countries were far far too much overlaid in terms of debt and budget deficits and of course there is no unified labour market in the Eurozone which is exactly what was required and to smoother the deficit and surplus.

People cannot move easily between Greece and Germany for example. So what we have at the moment is the realisation that some countries have cheated dramatically in the budget deficit possessions. We had the ECB stepping in and then saying we will buy government debt that’s made things worse. It hasn’t made things better.

Everybody was rejoicing at the beginning of last week with the ECB saying that it would buy up government debt, it would buy up private debt and would make sure that things didn’t fall apart. The natural fact is that it was the worst decision that they could have taken and the reason that it was a worst decision is that this wasn’t dealing over the financial system. It wasn’t a top programme to shore up the banking sector over the private sector.

This was trying to cover the cracks in the government sector and roughly those were not cracks. They were chasms especially in places like Greece, Portugal and Spain. It cannot be done and because of ECB action people have lost confidence and as a result of that there is an increase in sense of Europe quite rightly.

Eventually the Euro will become a much stronger currency based on a core number of countries. But I am afraid that the end game to this crisis is that it was going to be exit from the Eurozone - people were getting be thrown out probably rather than leave it and dealt with the stronger core Euro. But in the meantime the Euro will go much much weaker from here certainly.
Robert Shiller is saying that a second recession in the US may not happen this year but it will happen just like the 1937 recession in the US happened - a good four years after the 1929 to 1933 depression was over. What are your thoughts?

Yeah, there are various aspects to this but the most important is that the recovery end of in the US has been led by a huge stimulus programme. Interest rates are zero, government deficit at almost 10% and GDP up 5%-6% in one year. So of course that has pumped huge amounts of money.

People in the US are no longer paying mortgages. So their disposable incomes are actually going up in the last year because they don’t have any outgoings anymore. They are just setting there doing nothing until buying for closets.

But let’s speak very clear about the US economic data that the retail sales are back to around of 2007 levels, industrial production is at 2005 levels, most activity is way way down from where it was by end of 2007 beginning of 2008. The housing market is at 50-year lows - not even rebound that we would count as a rebound. So there is still very significant weakness in the US economy despite massive stimulus.

So what Robert Shiller is worried about is that when the stimulus begins to be withdrawn - and of course Europe is just a few months ahead of the US - the pressure will go on into the US to cut deficit very quickly and also to start tightening on monetary policy. When that happens the private sector is actually quite weak underneath the nearer strength at the moment and that’s all as Southern Euro strength unemployment properly measured.

At the moment the US would be 11.4% but is only 9.9 because so many people have jobbed the actual labour force. So that the possibility of falling back into may be not so much recession is, just cost to zero growth I think is very real for the US over the course of the next 12 months.

How are you mapping the economic environment for India because you have always talked about how you are bullish in India? How would you rate India now?

Yeah, I still look at India really more positively than most other countries in Asia and certainly most emerging markets. I think there are still some weak spots with India going through that the next year or I guess concern is actually growth. It’s not inflation, it’s not RBI tightening. I think RBI is not behind the curve.

The inflation has come for very specific reasons and will be dropping I think pretty quickly over the course of the next 6 months. But if we would look at the money and the credit from India - which are the growth supporting numbers - then what we see is really quite degree of weakness relative to where we were 2 or 3 years ago. That makes us a bit concerned that may be GDP is in a region of 6%-7% this year.

I would expect to come back relatively strongly and probably a degree of risk aversion within the Indian corporate sector remaining over the course of the next 12 to 24 months. That will further down growth. The downside means that the RBI certainly shouldn’t be tightening aggressively over the next few months.
You are talking about 6% to 7% economic growth for this fiscal year when most economist official and unofficial private sector are expecting at least 7.5% to 8%.

Yeah, we are basically belied because of the risk aversion trade coming back and that stops companies from investing strongly. A lot has to do with the monetary conditions in India at the moment which I say up in terms of credit growth and money supply growth slightly trending down. The credit side is much weaker than a few years ago and it doesn’t really adopt 8%-9% growth. It looks very much more or like 6% or 7% even with a good rebounding monsoon.

Government has set itself a very daunting budget deficit reduction target. It was to take the deficit number to 5.5% from 6.9%. But if GDP is not going to grow as strongly as people think, then do you think this deficit reduction target could be met?

I think it’s going to be very tough to meet that 6.9% to 5.5. India is predicated in strong growth at the nominal GDP level and that there will still be good growth at the nominal GDP level. But my guess is it may take the deficit down toward 6% of GDP that certainly knelt towards the 5.5% level which is really required. This is a much tougher stands on spending and government expenditure - specifically at the subsidy level more than anything else. That has to be cut back and we have to get into a much more structural decline in the fiscal deficit - not relying on growth but actually relying on rationalisation of the expenditures.

What is your view on the level of the index, where we may head from here onwards and which pockets do you think will sort of lead to the strong growth kicking in for the next few quarters?

Well I would be tending to be a bit more defensive in my portfolio selection on India at the moment just as I see concerns on my mind of that cyclical recovery. So I would be concentrating a lot more on consumer staples, utilities avoiding the deep cyclicals and we are avoiding the export companies as well and certainly the property sector we are bit worried.

So we would be looking at the defensive sectors. The return on equity in India is a almost guaranteed better than average return purely because India is central buying because it always kept interest rates high in response to the government deficits that means that the private sector considers the capital is scarce and therefore invest much more wisely than in many other countries out in the world.

(from economic times, May 17, 2010)

Saturday, May 22, 2010

Bruce Krasting: The Swiss Did It!?

Swiss National Bank President, Phillip Hillebrand, in an interview with the Neue Zuricher Zeitung, May 8, 2010:

We will not allow that the euro zone problems and an excessive rise in the franc to lead to deflation in Switzerland. That defines our policy with regards to the exchange rate. The bank will act in a decisive manner if needed.”

There has been a lot of speculation in the past 48 hours on who did what in the FX markets as far as intervention is concerned. The Treasury Department has a “no comment”. The ECB and the SNB have been mum. I will stick my neck out and say it was the Swiss that did it. A two-day chart of Euro/CHF:

The two vertical lines are evidence of market intervention. That is not just short covering. This was a size buyer that did not care if the execution was sloppy. It looks to me like an effort at “shock and awe”. Some thoughts:

-As of 3/31/2010 the SNB had Euro 53b in reserves. They reported that these holdings had a mark to market loss for the Q of CHF3.1b ($2.9b). The NZZ has reported that SNB purchased an additional Euro10b in April. It should therefore come as no surprise that the SNB bought more Euros and sold more CHF in the past day and a half.

-The graph shows that the FX rate was just a tad above 1.40 for a few days prior to the blow up. I suspect that this was the SNB providing support to the market on an ongoing basis. These are stabilizing efforts. It is a “containment" policy it is not “shock and awe”.

-The night of the Merkel “no trading” rules the Euro/$ hit a new low. Logically there would have been pressure on the Euro/CHF. But it held. Here I suspect that “resting orders” were in place to continue the containment.

-Watching the market on Wednesday I concluded that there were three separate rounds of intervention in the E/CHF. Each resulted in a spike in the rate and then a resumption of trading. The end result was a 2% backup. That is a big move in this cross. This activity all took place during peak European and NY FX markets. At that time there are thousands of players. The market is deep and big numbers can get done. The intervention required to move the market this much would have to be more than Euro 5b.

-The E/CHF rate was fairly quite today. Until 2 pm. Then another demand driven gap upward. I saw no reason in the other markets for this gap. If a “real” market player wanted/needed to buy size E/CHF they would not have done it a half-hour before the futures close. This stinks of “Shock and Awe”.

-The E/CHF market is a derivative of the $/Euro and $/CHF. To unwind demand for E/CHF one could buy $/CHF and sell $/Euro. The crosses have to match out with the cash prices. During European trading the CHF crosses all have big floats. But in late NY markets they do not. So if a big buyer of E/CHF appears it will result in a seller of $/Euro. (Demand for Euro). This explains why the E/$ rate went ballistic this afternoon.

But why? I am not sure. There could be many motives at play.

The SNB had every reason to intervene. They said they would and they did. They did what they have been doing for months. But in my opinion the shock and awe of the last few days is very atypical of the SNB. The question is, “Were they asked to change their strategy?”

The ECB has shown their hand. They have not actively intervened during European markets. If they had we would know about it. The ECB would have announced their efforts publicly. The job of the ECB is to manage a downward path for the Euro. They are well aware of the collateral damage to the other markets a weak Euro could cause. They need a weaker Euro, but they can’t afford a collapse of the bond/equity market. So Trichet calls up Hillebrand and says,

JCT: “Do us a favor. Make a very big bid in the E/CHF. This will help us out against the dollar, pound and Yen.” Hillebrand could have said,

PH: “Okay, we will step up to the plate over the next few days. First in Europe and the next day we will attack the weak Chicago market. But here is the deal, The ECB has to cover our losses. We'll roll them for you at Libor +2.”

JCT: “We’ll cover the losses. It doesn’t matter any more. Go out and kill some wolves for us.” (Heard muttering in the background: “Cheap Swiss”)

There is a Fed NY role in this. All Central Banks talk to each other (they also call big market makers). For me it is not possible for the SNB to have done anything in the NY trading hours without the knowledge, advice and consent of the NY Fed. This scares me a bit. We are in very nervous times. There has been no public statement of any intervention. So this is the stealth variety. I am not suggesting that the NYFed did anything today or yesterday. But if the SNB did, they had a chat:

SNB: “We are thinking of calling JPM in NY and putting in a market order to buy up to 3b E/CHF. What do you think?:

NYF: “Swell idea. The S&P is in the dumper. We are getting calls from all over. If you bid for size it will roll into the dollar market and bid up the Euro across the board. Is that what you want?”

SNB: “We are after the wolves today.”

NYF: “Suits us, Have at em. But one suggestion, do it at 2 pm. A few weeks ago a size order in Chicago at 2:30 caused a 10% micro burst in equities. Maybe you can do that again today. Wouldn’t it be a hoot if we actually killed a whole pack of wolves!

I don’t have a pipeline into the NYFed, the ECB or the SNB. This "take" on the market action in the past few days just lines up with the facts. If I am right, there are a few conclusions.

-The monetary authorities are very worried and are willing to use aggressive strategies to calm instability.

-Using the SNB as a single source of global currency intervention will not work for long. The ECB and the Fed are playing weak hands. They know if they intervene and fail it is lights out. So their active/visible participation is a last resort option.

-Another chapter in this story will be written soon. Possibly this weekend.

(from Bruce Krasting's blog, May 20, 2010)